Effectiveness of OTC Reforms Questioned

Terry Flanagan

Risk could end up being concentrated in fewer hands.

The effectiveness of new OTC clearing reforms is very much open to debate, industry participants say.

At a recent debate on collateral optimization hosted by University College of London (UCL) and organized by Rule Financial (a provider of business consultancy to global investment banks) and Calypso (a software provider of credit derivatives and cross asset trading), 50 percent of audience participants who were surveyed said that regulatory and market changes (e.g. Dodd Frank and EMIR) will not reduce systemic risk.

The survey was completed by 34 senior industry participants (c-level / heads of IT of global banks and market infrastructures).

A possible explanation is that regulations will hike the cost of collateral for OTC derivatives, which will lead to a drop in OTC volumes.

“We see the volumes of OTC trades going down and spreads also narrowing because of the advent of SEFs [swap execution facilities],” David Fields, executive director at Rule Financial, told Markets Media. “As volumes and spreads go down, profits could fall.”

With falling profits, the cost per transaction will go up, which will put a premium on economies of scale.

“As a result, risk could end up being concentrated in a small number of banks and clearinghouses, which is not what the regulators intended,” said Fields.

Of the OTC market players surveyed, 38% said their firms were undecided about centralizing their collateral management systems, highlighting how unprepared the industry is for new regulations around collateral requirements.

However, with 38% of survey respondents saying their organizations are still undecided about what type of collateral optimization software they might use, time is rapidly running out for those firms seeking to capitalize on the new collateral requirements as soon as they come into force, said David Little, director of strategy and business development at Calypso.

Calypso this year launched a collateral optimization solution specifically designed to address major functional gaps in the industry.

A key component of the solution is a proprietary algorithm that allows users to intuitively manage the collateral allocation process.

The solution is aimed at both buy and sell-side organizations that are looking to manage their collateral management more efficiently and in real-time. “Collateral management is now a very different game as businesses have become more focused on real-time collateral valuation and availability,” said Little. “The collateral management team has become an integrated part of the front office team, driving business decisions that are made based on real-time market data.

A ‘magic circle’ of top tier banks is emerging, who are spending between £25-30 million a year on collateral management infrastructure, according to Fields. Those outside the magic circle will be forced to play catch up.

“Here we are with a deadline at the end of 2012, and banks are still working out their strategy,” Fields said. “Once they have a strategy in place, they will either build their own software, or more likely, will choose an outside provider.”

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